Friday, December 30, 2011

Scotiabank
has released its Global Real Estate Trends research publication for December
2011 and it contains some very interesting data and observations.

The
author, Adrienne Warren, opens by noting that four factors are working against
the global housing market; the slow pace of the economic recovery, weak
consumer confidence, high unemployment and the sovereign debt crisis. Of
the real estate markets in the ten developed economies that Scotia bank tracked
in the third quarter of 2011, average real home prices were below last year's
levels in seven. The best performing market was Canada and the worst was
Ireland with the United States coming in at seventh place and the United Kingdom
coming in at sixth place. Let's take a more detailed look at several of
the markets in the report.

Ireland,
the worst performer among the ten nations, saw its year-over-year housing
market down by 14.7 percent in real terms, adding up to a cumulative drop of 44
percent from its highs in early 2007. This drop has pretty much negated
the real estate price increases Ireland has seen over the past decade.
Between 1992 and 2007, house prices in Ireland rose by nearly 330
percent, largely as a result of massive growth in the country's economy (recall
the long-extinct Celtic Tiger?). This was both the biggest and longest
housing boom. With a drop of 44 percent, Ireland has now seen the largest
downward price readjustment, however, its house prices still retain the largest
cumulative price growth among the sample nations suggesting that the correction
may not yet be over. From the graph it is also apparent that the downward
slope is still quite steep, suggesting that prices have not levelled.

2.) United
Kingdom: Here
is a graph showing the United Kingdom's real house price index since 1995:

House
prices in the U.K. are declining again after a short-term recovery in 2010 with
real home prices declining by 6.7 percent on a year-over-year basis. Over
the period from 1995 to 2007, real house prices in the U.K. rose by 174 percent
and fell 15 percent from the 2007 peak to the third quarter of 2011.

3.) Australia: According
to Demographia, Australia’s major cities suffer from some of the world’s least
affordable real estate when prices are measured in terms of household income. Australia’s median multiple (dividing
median house price by median household income in that market) of 7.1 indicates
that homes in the major centres are “severely unaffordablte. Between 1996 and 2010, Australia saw its house prices increase
by 125 percent. The market
suffered a 5 percent decline in 2010 on a year-over-year basis.

4.) United
States: Here
is a graph showing the United States' real house price index since 1996:

Between
1995 and 2005, the United States saw real price growth of 50 percent in its
housing market. A sharp reversal in 2006 has resulted in cumulative
downward price readjustment of 31 percent with a year-over-year drop of 7.5
percent in the third quarter of 2011. Unfortunately, a stagnant job
market, oversupply of foreclosures and unsold homes and tight credit conditions
have led to a very moribund housing market. Here is a graph showing the slump in the leading U.S. housing indicators:

With
prices, home sales and housing starts moving sideways during 2011, one would
think that demand for housing would be rising. Unfortunately as I noted
above, that is not the case despite the fact that home prices are now among the
most affordable as valuations have fallen below long-term trends. Weak
income growth and weak employment gains are dragging the market sideways, resulting
in consumers that are reluctant to purchase real estate. As well, an
oversupply of housing has kept new construction growth at a minimum with the
number of vacant homes alone standing about 600,000 above its long-term trend.
One thing working in the favour of future housing price increases is the
drop in American household debt levels as shown here:

Household
credit has now fallen from its peak of 164 percent of household disposable
income to 146 percent in the third quarter of 2011. While still high,
this readjustment is a marked improvement and if the trend continues, it could
provide a boost to the housing market as consumers feel that their financial
situation is more stable.

On top of these factors, annualized new housing construction is just over 600,000 units. This
is well below the long-term replacement value of 1.5 million homes per year.
This has resulted in a record low level of unsold new homes. Should
the aforementioned factors of employment, economic growth and household debt
correct themselves, this dearth of new homes could quickly lead to a
supply/demand imbalance which could push prices up quickly in some areas where
there is not a massive inventory of foreclosures.

In
the period between 1998 and the present, Canada has not seen a downward price
readjustment, in fact, among the nations in the study, Sweden, Switzerland and
Canada are the only nations that have seen steady price appreciation with
prices at or near record highs. Over that timeframe, Canadian real estate
prices have risen by an inflation-corrected 85 percent, relatively small when
compared to some of the European nations in the study. On a year-over-year
basis, prices rose by 4.8 percent in the third quarter of 2011 with some leveling
off of prices in November due to economic uncertainty. Canada’s housing
boom is now in its 13th year, just behind Ireland and Sweden's 15 year boom.

Here
is a graph showing how both the number of sales and how real estate prices in
Canada have risen since 1990:

Let's
just say that its been a good decade to be a realtor!

A
great deal of this boom in Canada's real estate can be attributed to ever lower
mortgage interest rates as shown on this graph:

Mortgage interest payments have fallen from just below 7 percent of household disposable income in

the early 1990s to roughly 4 percent in 2011, largely due to the current ultra-low interest rate environment. The peak of 7 percent in the early 1990s was due to mortgage interest rates ranging between 14 and 15 percent.

As mortgage payments as a percentage of household disposable income have fallen, purchasers have been lulled into thinking that the current low interest rate environment is the new norm and that their payments will never increase. With today's far higher real estate prices, mortgage debt servicing could well become an issue if interest rates rose to even half of their two decade peak. While Canada prides itself on its stellar banking industry, the balance sheets of Canada’s banks could look a bit less beautiful if interest rates rose and mortgage arrears rose in tandem.

While I realize that some of the issues facing the real
estate markets in other nations are specific to the economies of those nations and that they are
unlikely to impact Canada' real estate market, one should never say never.
With Canadians facing record high household debt levels, the day of
reckoning could be just around the corner if interest rates rise even modestly
and consumer debt becomes less serviceable. No one thought that the
United States' real estate market would crash in 2006 - 2007, did they?
Apparently, they were very, very wrong.

Wednesday, December 28, 2011

Updated November 2013Back
in late November, I posted an article outlining Iran's contribution to the
world's natural gas resource base. As you may recall, Iran is one of the
world's leading producers of both natural gas and oil; it is OPEC's second
largest oil producer and exporter after Saudi Arabia and, in 2010, was the
world's third largest exporter of oil after Saudi Arabia and Russia. In
this posting, I will be taking a look at Iran's oil industry, particularly
since they have threatened to shut down the Strait of Hormuz, a very narrow
body of water near the exit and entry point of the Persian Gulf through which passes 15 million BOPD or one-sixth of the world's supply of oil.

Iran
is a founding member of OPEC. According to OPEC's website, Iran has the third largest oil
reserves among the 12 nations that comprise the cartel as shown here:

OPEC's
oil reserves of 1193 billion barrels make up 81.33 percent of the world's total
oil reserves. Among OPEC nations, Venezuela has the largest reserves totaling
296 billion barrels and Saudi Arabia has the second largest at 264 billion
barrels. With reserves of 151.17 billion barrels, Iran has 12.7 percent
of the world's total oil reserves. Iran is OPEC's second-largest oil
producer and the world's third-largest crude oil exporter (or fourth largest
depending on the source).

Here is a map showing Iran's main oil and gas
fields and pipeline infrastructure:

Iran
has 40 producing oil fields, 27 onshore and 13 offshore with
medium sulphur content crude and gravities ranging from 28 to 35 degrees API. Onshore
fields comprise just over 70 percent of Iran's total oil reserves with
over 50 percent of the nation's reserves confined to just six supergiant fields
including its largest field, Ahvaz. The vast majority of the fields are
located in the northwestern part of the country adjacent to the Iran-Iraq
border. Data available from OPEC suggests that Iran exported
approximately 2.438 million BOPD to Asian and OECD European nations; in
comparison, the United States Energy Information Administration (EIA) estimates
that Iran exported over 2.2 million BOPD in the first half of 2011. As of
2008, Iran was producing an estimated 4.3 million BOPD of which roughly 3.8
million BOPD was crude oil. At these rates, if no additional oil was ever
discovered in Iran, the country's reserves would last for 95 years. In
2008, Iran consumed 1.73 million BOPD of its own production; these levels are
rising as the population grows since most of the domestic consumption is
related to the use of both diesel and gasoline. Here is a graph showing Iran's total
oil production and consumption over the last 4 decades:

One
of Iran's energy and fiscal problems relate to its high level of energy subsidy. In
2009, Iran's gasoline price was approximately 10 cents per litre. The
Iranian government proposed removal of these subsidies which would have raised
the price of gasoline to 40 cents per litre, a 400 percent increase. Here
is a look at other proposed energy price changes which were announced in
December of 2010:

Here is a graph showing how rapidly Iran's gasoline
consumption rose over the past three decades:

Interestingly
enough, this energy-rich country had imposed gasoline rationing which began in
2007. In the three years following rationing, the gasoline quota per
individual was reduced from 120 litres per month to just 60 litres per month!

Just
prior to the Iranian Revolution, Iran's oil production was in the 6 million
BOPD range. Imposition of international sanctions and a high rate of
decline in Iran's oil fields pushed daily oil production down to approximately
1.5 million BOPD by the early 1980s. This has since risen to around 4
million BOPD and it is estimated that in 2011, Iran's crude production has been
in the range of 3.6 to 3.65 million BOPD, above its OPEC target of 3.34 million
BOPD. Natural declines in Iran's aging oil fields are an ever-present
problem; an estimated 400,000 to 700,000 BOPD are lost to natural declines on an annual
basis. To combat this, Iran's oil fields require massive infrastructure
investment including enhanced oil techniques using injection of the nation's massive natural gas resources to repressurize reservoirs.

Most
of Iran's oil exports end up in Asia. Here is a chart showing Iran's top
export destinations for 2010:

Iran's
largest volume of exported oil is comprised mainly of Iranian Heavy Crude. In
2010, Iran's net oil export revenues were approximately $73 billion, providing
roughly half of Iran's government revenues. For the first half of 2011,
China, India, South Korea and Turkey have all increased their imports of
Iranian crude as export volumes are reallocated to countries that have less
stringent sanctions in place. Here is a chart showing how export levels
by country have changed (increased for Asia (excluding Japan) and decreased for Italy) for the first half of 2011 as compared to 2010 above:

A
number of new oil discoveries have been made in Iran over the past 2 years. The
National Iranian Oil Company (NIOC) announced the discovery of light oil in the
Khayyam offshore field in May 2011; the field has estimated recoverable oil reserves of
170 million barrels. As well, at the same time, Iran announced the
discovery of new onshore oil and gas fields in the south and west of the
country that contain an estimated 500 million barrels of oil.

Development
of the infrastructure necessary to produce oil from new discoveries is hindered
by international sanctions. The massive North and South Azadegan Fields
(discovered in 1999) contain 26 billion barrels of proven oil reserves in a
very complex reservoir. China, through its China National Petroleum
Corporation (CNPC), is developing the north portion of the field. Japan's
INPEX had signed an agreement to develop the southern portion, however, it
pulled out of the project in October 2010 due to international pressures. Guess
who stepped in? You're right - a subsidiary of CNPC! China has
agreed to invest $8.4 billion over the next 10 years. As well, China's
Sinopec has signed on to develop another promising field, Yadavarn, which
should be producing up to 185,000 BOPD by 2016. Overall, according to FACTS Global Energy, Iran's discoveries of crude oil
and condensate totaled 10.7 billion barrels of oil in 2010 alone.

From this posting and my posting on Iran's natural gas resources, you can see that Iran is most certainly
key to the world’s overall energy picture. While they have become a pariah state in the eyes of many
world leaders, their production contribution to keeping the world’s oil
production levels at or above the overall level of demand cannot be denied. With that in mind, it will be
interesting to see how long it takes before the leaders of the developed world
take matters into their own hands and enact measures that will result in regime
change, all in an effort to control Iran’s massive energy resources. As I've pointed out before, one thing will hinder their plans; it will take a massive effort to unseat China from their role as supplier of capital to the resource-rich pariah nations of the world.

The
Government Accountability Office (GAO) recently released its 2011 Financial Report of the United States Government. I actually like this report;
since I have a business background, I find that it reads more like a corporate
annual report. In this case, the Financial Report provides the President,
Congress and Main Street America with a comprehensive look at how the Federal
Government is (mis)managing taxpayer dollars by outlining the Government's
financial position, its revenues, costs, assets and future liabilities.

That
sounds, well, rather sobering, doesn't it, especially since it's coming from a
former Fed President?

Here's
a snapshot of the condition of America's finances at the end of fiscal 2011 compared to:

If
you think of this as a report card for both the Presidency and Congress, one
would have to think that any teacher would assign a letter grade of
"F". Now, let's break down the data a bit further.

Here
is a graph showing the United States' budget deficits and net operating costs
for the past five years:

The
budget deficits of fiscal 2010 and fiscal 2011 were nearly identical at $1.294
trillion and $1.299 trillion respectively; a slight increase in revenue for
2011 and a decreased net cost (due to a drop in costs for federal employee and
veteran's benefits and a decline in the cost of economic recovery programs) led
to a drop in 2011 net operating cost to $1.313 trillion, down from $2.080 trillion
in fiscal 2010. Basically, it was the so-called "economic
recovery" that reduced overall net operating costs; when the economy heads
south again (as it surely will), net
operating costs will rise as they did between 2007 and 2010 as government tosses
more stimulus dollars into the pot.

The
GAO is quite concerned about the long-term fiscal challenges facing the United
States. Here is a graph showing the GAO's frightening fiscal projections for overall spending both including and excluding interest on the debt and revenue to 2086 as a percentage of GDP:

You
will note the massive increase in net interest spending as time passes. The
cost of the debt is expected to rise as a percentage of GDP even if both
federal government spending and receipts remain at a relatively stable 20
percent of GDP. Net interest costs alone will ultimately reach over 15
percent of GDP due to increased debt levels, a scenario that is most likely
unsustainable.

Now,
let's look at government revenues for 2011. First, the level of corporate
profits rose in fiscal 2011 but at a slower rate than in fiscal 2010. Despite
the rise in corporate profits, corporate tax revenue dropped by $4.5 billion
(or 2.5 percent) on a year-over-year basis as shown on this graph:

As
I've posted previously, you will notice how corporate tax receipts declined in
2011 despite the fact that the economy was improving. As well, corporate
tax receipts are less than half of their level in 2007, prior to the beginning
of the Great Recession.

The
level of personal income tax revenue rose by nearly $133 billion from fiscal
2010 to fiscal 2011, an increase of 7.7 percent. Personal tax revenue is
now at 90 percent of its pre-Great Recession peak in 2008 compared to corporate
tax revenue which is at only 48 percent of its pre-Great Recession peak in
2007. Perhaps corporations really do need a cut in the 35 percent levy! What
I find interesting is the 7.7 percent year-over-year rise in personal tax
revenue when one considers that the job market is hardly what could be termed
as robust; U3 unemployment was stubbornly stuck in the 9 percent plus range all
year and more comprehensive unemployment statistics showed unemployment levels
well in excess of 15 percent as the Shadow Government Statistics website shows here:

Now,
let's take a quick look at where Washington spent its windfall. Here is a
pie chart that breaks down where government allocates your tax dollars:

The
bulk of spending is in three areas, Department of Health and Social Services,
Social Security Administration and the Department of Defense. Each of
these consumes between 20 and 24 percent of Washington's revenue.

Here
is a graph showing Washington's assets and liabilities:

Washington
(or rather, taxpayers) owns about $2.707 trillion in assets comprised mainly of
property, plants and equipment ($852.8 billion) with the remainder in paper
including net loans receivable, those lovely mortgage-backed securities and
other investments ($985.2 billion). The problem with government assets
like property and equipment is that their value is often difficult to
accurately assess; for instance, what is the value of a National Park and is
there a even a market for such a property? On the liability side of the
ledger, Washington has $10.174 trillion worth of debt securities outstanding (Treasuries
plus accrued interest), Federal government employee post-employment benefits
and veteran's benefits totaling $5.792 trillion and other liabilities of
$1.526 trillion for total liabilities of $17.493 trillion. Doing the arithmetic results in net
liabilities of $14.785 trillion. On top of this debt, there is intragovernmental
debt which occurs when one part of the Federal government "borrows"
from another; this debt totals $4.7 trillion. This represents government
debt held by government trust funds including the Social Security and Medicare
Trust Funds which are required to invest excess annual receipts in Federal
government debt securities. Because these are liabilities of the Treasury
and assets of the Trusts, they cancel each other out.

From
the report, here is a graph
showing the projected non-interest spending by the government for the next few decades:

The
difference between non-interest spending and what the government takes in is
termed the primary deficit or primary surplus. You will notice the black line showing Washington’s total revenue
as a percentage of GDP; where the coloured portion of the graph rises above the
black line, there is a primary deficit (remembering that the primary deficit
excludes interest owing on the debt). The primary deficit soared in 2009,
2010 and 2011 as the government bailed out the economy (i.e. TARP et al). During
those 3 years, the primary deficit reached nearly 10 percent of GDP both
because of increased spending and decreased tax revenues. That is
expected to drop to the point where there is a small primary surplus between
2015 and 2019 as the spending reductions in the Budget Control Act kick in. The
primary surplus ends in 2020 as spending on Social Security, Medicare and
Medicaid rise; the primary deficit is expected to peak at 1.3 percent of GDP in
2035. You will notice that this projection does not include the
possibility of another Great Recession that would require a massive federal
government bailout as was the case in 2009 - 2011. That is why the black
line and the coloured areas are so smooth as we move into the future. Looking
back, one can see that the recessions of the early 1980s, 1990s and 2000s
resulted in far higher primary deficits than would have been projected prior to
their arrival. The same holds for the future with one difference; the increased
spending on entitlements will mean that the Federal government is starting from
a primary deficit rather than a primary surplus, making the fiscal situation
even more difficult to control.

As I
mentioned earlier, the GAO is concerned about the changing demographic that
will impact the fiscal picture in the future; America’s aging population will
result in persistent growth in Medicare, Medicaid and Social Security costs. Here’s
a quote from the report:

"Largely
as a result of the provisions in the Budget Control Act of 2011,4 the fiscal
outlook has improved. However, rising health care costs and the aging of the
U.S. population continue to create budgetary pressure. The oldest members of
the baby boom generation are now eligible for early Social Security retirement
benefits and for Medicare benefits. In addition, debt held by the public
continues to grow as a share of the economy; this means the current
structure of the federal budget is unsustainable over the longer term." (my bold)

According
to the Medicare Trustees' Report, spending on Medicare alone is expected to
rise from 3.7 percent of GDP in 2011 to 5.6 percent in 2035 and 6.2 percent in
2085. The Hospital Insurance Trust Fund is expected to remain solvent
until only 2024 after which time, tax income will only cover 90 percent of
benefits, declining to 76 percent
in 2050.
Social Security costs are expected to rise from 4.8 percent of GDP in 2011 to
6.2 percent in 2035 and declining to about 6.0 percent by 2050. The
Social Security Trustees' Report notes that the annual Old-Age, Survivors and
Disability Insurance Trust Funds (OASDI) income will exceed annual costs until
2023 at which point it will be necessary to begin drawing down the trust fund
assets until assets are exhausted in 2036. After funds are exhausted,
tax income will cover only 77 percent of benefits in 2036 and 74 percent in
2085.

Let’s
look at what happens to growth in the primary deficit as a percentage of GDP if
health care cost growth is more rapid than projected:

If
Medicare and Medicaid expenses grow just 2 percentage points faster than the
GAO projects, the primary deficit (excluding interest on the debt) reaches 20
percent of GDP by 2085. This doesn't sound like much until you put the number into
perspective. Right now, the entirety of Federal government spending as a
share of GDP, once again excluding interest on the debt, is 22.6 percent. To
put the deficit into dollar terms, the 75 year present value fiscal imbalance
of this 2 percentage point increase in Medicare and Medicaid spending is a
rather scary $66.5 trillion or just over 4 times the current level of the entire
federal debt.

When
we take all of this data into consideration along with projections for interest
rates and GDP, here is what we end up with:

Over
the next 75 years, the debt-to-GDP ratio is projected to rise to 283 percent,
down markedly from the projections of 352 percent in last year's Financial
Report, largely because of spending reductions called for in the Budget Control
Act of 2011. While this may appear to be a meaningful improvement, a
projection is just that, a projection.
From the graph showing what happens when spending on Medicare and
Medicaid increase by just 2 percentage points, you can see how sensitive the
projections are to small increases in spending or declines in revenue.

The
sooner Congress makes meaningful progress towards fiscal consolidation, the
less painful it will be for America. If reform begins in 2022 rather than
immediately (assuming an immediate reform of 1.8 percent of GDP), the primary
surplus must be raised by 2.2 percent of GDP, by 2032, the primary surplus must
be raised by 2.8 percent of GDP just to keep the debt-to-GDP level in 2086 equivalent
to the level in 2011. The increased cost incurred by delaying is a result
of rising interest on the rising debt level.

Let’s
close this rather lengthy posting with one last quote from the report:

"If
a higher debt-to-GDP ratio increases the interest rate, making it more costly
for the government to service its debt and simultaneously slowing private
investment, the primary surplus required to return the debt-to- GDP ratio to
its 2011 level will also increase. This dynamic may accelerate with higher
ratios of debt to GDP, potentially leading to the point where there may be
no feasible level of taxes and spending that would reduce the debt-to-GDP ratio
to its 2011 level." (my bold)

Friday, December 23, 2011

I
just wanted to wish all of my readers, followers et al a Merry Christmas and
Happy New Year. I'm not certain that I'll be posting any further
diatribes over the Christmas break so I'll leave you with this rather
interesting "Not Christmas" news item. I just thought that it
would be a nice change to post something that wasn't quite so
"intense", unless of course, you happen to be the lady involved.

According
to this case report by Doctor Oliver Richard Waters that
I found on the BMJ website (formerly known as the British Medical Journal), it
seems that a 76 year old female presented with weight loss and diarrhoea. Other
than that, she was in good health. She underwent a sigmoidoscopy (a
rather fun procedure if you haven't had one!) and the physician noted that she
had severe diverticulosis or small bulges in the inner lining of her large
intestine. A CT scan of her abdomen showed a linear foreign body located
in her stomach as shown here:

After
questioning her further, the patient recalled that, 25 years earlier, while she was inspecting a
spot on her tonsil with a pen, she slipped, fell and swallowed the pen. Her
husband, a general practitioner, dismissed her story because x-rays done at the
time showed up nothing. Her 21st century physician performed a
gastroscopy (another one of those fun medical procedures!) and extracted a
plastic felt-tip pen. The pen was subsequently removed and, surprisingly,
still worked as shown here:

Notice
that the first words that the pen "spoke" after seeing the light of
day for the first time in 25 years was a much relieved "hello"?

Here
is the summary of the case report:

"This
case highlights that plain abdominal x-rays may not identify ingested plastic
objects and occasionally it may be worth believing the patient’s account
however unlikely it may be."

Once again, have a Merry Christmas and please keep all of those plastic pens
away from your tonsils!

Wednesday, December 21, 2011

Updated April 2013Some
months ago, I wrote a posting about both federal and state pension plans, the
funding gap between their current balances and their future liabilities and how
this was going to impact American taxpayers who are on the hook for the
shortfall. Thanks to the C.D. Howe Institute, a Canadian think-tank, we
now have a brief entitled "Ottawa's Pension Gap: The Growing and
Under-reported Cost of Federal Employee Pensions" which outlines how the issue
will impact Canadian taxpayers. Let's dive in and see what the authors,
Alexandre Laurin and William Robson, had to say.

Canada's
public servants are beneficiaries of defined benefit pension plans (DB). Three
of the largest federal government DB pension plans are provided to the Public
Service, the Canadian Forces and the RCMP. On top of that, Members of
Parliament and federal judges have special plans; those of MPs are considered
by many to be the ultimate in gold-plated pensions since they qualify for the MP
pension after just six years of service which they can collect at the advanced
age of 55. How many of us could say that? According to the Canadian Taxpayers Federation, the current DB pension plan
requires taxpayers to fork over $5.50 for every $1 contributed by any given MP.
For your illumination, here is the Canadian Taxpayers
Federation calculations for pensions and severance payments owing to the MPs
that were defeated in the May 2011 General Election.

Back
to the C.D. Howe brief. In the private sector, DB pension plans must
calculate the difference between their future obligations and assets using
actual market yields. Not so for public sector pension plans. Public
sector plans are allowed to use made-up rates of return to value their plans. Unfortunately,
generational lows in interest rates have made these assumed rates of return
unreasonable, resulting in growing unfunded liabilities.

Canada's
public sector pension assets total $54 billion in 2011, future accrued
obligations total $213.3 billion and unamortized estimation adjustments total
$13.2 billion for a total future liability of $146.1 billion. However, if
one replaces the government's current smoothed liabilities of $213.3 billion
with a fair value approach that better reflects market rates of return that are
currently available. Right now, the government is using a real assumed
rate of return of 4.2 percent (note, that's the nominal or posted interest rate
plus 4.2 percent for inflation) on all fund assets for benefits that were
earned since 2000. The government also uses a moving average of past
nominal yields on 20 year federal bonds in its calculations, again, these rates
are well above what one would expect in the past few years.

If
an individual Canadian wanted to set up a pension plan that mirrored the plan
available to Canada's public sector workers, they would have to index their
savings to inflation. The best measure of this index is a Canadian
government real return bond. This is where the problem crops up. As
noted in the previous paragraph, Ottawa is using a real return of 4.2 percent;
unfortunately, the actual return on the real return bond is now just over
one-half percent. According to the Bank of Canada website, real return bond yields have
ranged from a high of 3.76 percent in December of 2001, falling to 0.53 percent
in December 2011 with an average of 2.07 percent over the 10 year period. Here
is a graph showing all of the data:

We
can now readily see that the 4.2 percent real return is highly optimistic. The
C.D. Howe recalculated the assets that would be required to fund Ottawa's
pension promises using a "fair value" 1.15 percent yield and finds
that Ottawa's obligations would rise from $213.3 billion to $285.2 billion. If
one subtracts a new assets fair value of $58.6 billion, the unfunded pension
liabilities rise from $146.1 billion to $226.6 billion, a difference of $80.5
billion. If one substitutes the current 0.5 percent rate on real return
bonds, the future funding shortfall is even greater. Since the Canadian
taxpayer will ultimately be responsible for these shortfalls, the $80.5 billion
should actually be added to Canada's debt. According to Statistics Canada's latest economic and
financial data report, Canada's accumulated federal debt reached $568.140 billion
as of September 2011. If we add in the realistically calculated unfunded
public sector pension liabilities, the debt rises by 14.2 percent to $648
billion. Since, in fact, this $80.5 billion shortfall was accrued over a
number of years, the surpluses of the past decade were actually smaller than
reported and the deficits were larger. For example, the 2010 - 2011
deficit would have risen from its reported value of $31 billion to almost $47
billion, a rather significant change.

Another
point of concern is the growth in the funding gap. Here's how the growing
gap between reported pension obligations and the fair-value estimate has looked
over the past decade:

The
authors suggest that the Canadian government has two ways to fix this mounting
problem:

1.)
Eliminate the final-salary-based DB plan and replace it with a
career-average-salary plan and eliminate the early retirement option.

In summary, the rising gap between Canada's public service
pension assets and its future liabilities should concern every Canadian since
we are all ultimately responsible for the shortfall. Just as Canada's
private sector employees are looking to retire, they may find themselves paying
much higher taxes to fund their country's public sector pensions. That
will most likely be a terribly unpalatable prospect.

Tuesday, December 20, 2011

Over
the past few months, I am always amazed when I see how the world's major bond
ratings agencies view the current level of sovereign debt. In particular,
I have been shocked that the debt wall facing the United States has
garnered very little in the way of a downgrade, perhaps a slap on the fingers
with a wet spaghetti noodle at most. Thus far, the downgrade and warning have
provided very little impetus for Congress and the President to meaningfully
change their spend more and then tax less philosophy.

Fortunately,
however, there is a very small ratings agency located in Jupiter, Florida, that
takes a far more pragmatic view of America's debt problems. Weiss Ratings, an independent ratings agency, uses far tougher standards than other
ratings agencies because they are primarily a consumer oriented agency,
providing risk-adverse consumers with a means to better understand investment risk.
They have a reputation as a very conservative ratings agency and use a
different letter grading system that is more intuitive than a series of A's,
B's and plus and minus signs. Weiss rates banks, insurance companies, and
credit unions so that consumers can avoid depositing their hard-earned money
with companies that are financially weak. Fortunately, Weiss also rates
sovereign debt, the subject of this posting.

As I
mentioned before, Weiss's ratings scheme is far more intuitive since most of us
passed through elementary school at one time or another and have very clear
memories that E's and F's were very bad and were probably going to get grounded, D's weren't so hot, C's meant you had
some problems that would require extra homework and A's and B's meant that you were doing well.

Now
let's get down to the specifics of Weiss's ratings for sovereign debt. Weiss
analyzes data from the IMF and other government sources to determine a
country's rating. They look at four factors:

1.)
Debt Index: The debt index measures the country's reliance on debt and
deficit financing in proportion to its population and the overall size of its
economy.

2.)
Stability Index: The stability index measure the country's strength in
terms of its currency, reserves, status as a world reserve currency and default
history.

3.)
Macroeconomic Index: The macroeconomic index measures the long-term
sustainability of the economy including GDP growth, unemployment and inflation.

4.)
Market Acceptance Index: The market acceptance index measures the ability
of the government to raise additional debt on the world's bond markets.

Here
are their ratings for sovereign debt:

A -
Excellent - The country's finances are in excellent shape with good budgetary
and debt management. It has a strong economy with good ability to raise
additional funds in global markets as required. Risks to bondholders
relate to interest rate and exchange rate fluctuations only.

B -
Very Good - The country's finances are in good shape with at least good scores
in all four factors. Most risks to investors involve interest rate and
exchange rate fluctuations as noted above.

C -
Fair - The country's finances are in fair condition although in the event of
adverse economic conditions, it may encounter difficulties in maintaining its
financial stability. Investors in bonds from these countries face
potential losses if there are sustained declines in the country's medium- or
long-term government securities that exceed those that are strictly related to
rising inflation. Losses could also be incurred from a serious decline in
a nation's currency.

D -
Weak - The country is in a weakened financial condition with poor results on at
least one of the four factors. It could have a heavy debt load,
inadequate reserves, poor economic growth or an inability to raise additional
funds on the world's bond markets. Risk to investors includes the threat
of default. Sovereign debt investments in C-rated countries should be
considered speculative.

E -
Very Weak - The country has very severe financial weaknesses that make
investment in its securities highly risky. Investors face very high risk
of loss of investment capital because of bond price declines, currency
collapses or default. Sovereign debt investments in D-rated countries
should be considered extremely speculative.

That's
enough background. Now let's look at what Weiss has to say about the
United States and Canada.

1.)
United States: To open, Weiss quite clearly states that they are not big
fans of the AAA ratings assigned by the major ratings houses to United States
sovereign debt. Here is a quote:

"We
believe that the AAA/Aaa assigned to U.S. sovereign debt by Standard & Poor’s
(S&P), Moody’s and Fitch is unfair to investors and savers, who are
undercompensated for the risks they are taking. An honest rating for U.S.
government debt is urgently needed to help protect investors and support the
collective sacrifices the U.S. must make in order to restore its
finances."

Weiss definitely does not go out of its way to be kind to the United States. They rate United States'
sovereign debt as meriting a grade of C, putting them in 44th place out of 47
nations in terms of its debt burden primarily because of its consistently large
deficits, 32nd place for its international stability due to its low reserves,
27th place for economic growth because of the swings in its economic growth pattern
and 6th place for its ability to borrow in the international bond marketplace,
largely because the United States dollar is regarded as the world's reserve
currency. Overall, the United States comes in 33rd place out of the 47
nations in Weiss's ratings "world".

Here
is Weiss's summary of their reasoning behind their assessment:

"The
C rating signals that the current fiscal condition of the United States
government is far inferior to that implied by its AAA/Aaa rating from other
agencies. At the same time, it means that the U.S. retains enough borrowing
power in the marketplace to give it the opportunity to take remedial steps.
Still, there are grave risks for policymakers and investors, including the
possibility of a vicious cycle that includes severe declines in U.S. bond
prices and the U.S. dollar.

Although
our opinion of U.S. sovereign debt contradicts the AAA/Aaa rating assigned by
the U.S. credit rating agencies, it is supported by a large body of new
research published by governmental and international organizations. Moreover,
in creating its sovereign debt ratings, Weiss Ratings ensures fairness by
avoiding conflicts of interest and focusing exclusively on objective,
quantifiable criteria without cultural or political bias."

Weiss
feels that the AAA/Aaa ratings assigned to United States sovereign debt
securities is misleading investors because it fails to warn investors of the
true risk involved, meaning that investors are undercompensated for the risk
that they are taking when holding United States Treasuries. Most
importantly, Weiss also notes that:

"The
AAA/Aaa U.S. debt rating has continually fostered political resistance and
gridlock in Washington. If an appropriate rating had been issued years ago, it
could have played a pivotal role in helping lawmakers and policymakers take
earlier remedial steps." (my bold)

Perhaps
Weiss is correct; until there is a meaningful downgrade in the rating of United
States sovereign debt, action on the part of Washington will not be
forthcoming. After all, until you are punished, you have no incentive to change your behaviour! One need look no further than the recent example of the
Eurozone to see what has happened when the major ratings agencies downgraded
the debts of several European nations by several steps at a time. Certainly,
the Eurozone's problems are far from over but at least discussions are being
held and modest headway is being made. The same cannot be said for the
United States where vitriolic partisan politicking takes the place of
meaningful fiscal change.

2.) Canada: Weiss downgraded Canada from
C to C- on December 19th, 2011. Weiss states that Canada is expecting
slower-than-expected economic growth and rising unemployment which will make it
increasingly difficult for Canada's government to balance its budget. As
well, due to close economic ties with the United States and Europe, Canada is
in the line-of-fire and cannot possibly hope to sidestep the world economic
slowdown as it relates to the Eurozone debt crisis. Weiss also notes that
reduced government receipts will make it difficult to achieve fiscal balance. This
assessment is not that far off from what Canada's Parliamentary Budget Officer
noted in his appraisal of Canada's chances of fiscal balance in his most recent
PBO Economic and Fiscal Outook in November 2011.

To
put these ratings into perspective, Weiss rates Austria as a C+, Belgium as a
C-, the United Kingdom as a C-, Turkey as a C-, Ireland as a D-, Spain as a D+, Portugal as a D+, Brazil as
a C, Greece as an E and Australia as a C+. Austria, Belgium and Turkey
have all noted declines in their ratings in recent months due to deteriorating
conditions in the stability of their financial markets. It is interesting to see Canada and the United States dwelling in the Eurozone debt transgressors neighbourhood, isn't it? Weiss's A-rated nations include Switzerland, Singapore, China and Malaysia.

As a hobby economist, I really like the Weiss ratings
system. Not only is it easier to understand for lay people, I think that
it better reflects the true situation of the fiscal stability of both Canada
and the United States. While the governments of both nations just love to
strut about and proclaim that their debt has among the world's highest credit
ratings, their grasp on reality is tenuous at best. Weiss's grasp of the
real issues that will ultimately impact the creditworthiness of nations seems
to be far more compelling. After all, one cannot go on making a dollar and
spending a two dollars forever. The folks at Weiss seem to be aware of
that fact. Unfortunately, our politicians do not.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.